On Bubbles, Inflation and Overcapacity

The global central banks have flooded the world economy with hot money for years. Why has this created massive asset bubbles rather than inflation?

In the 1970s, expanding credit triggered a decade-long bout of high inflation as cheap money chased scarce goods. Why hasn't the massive expansion of credit/hot money of the past decade caused inflation? Short answer: overcapacity.

Let's look at a few charts to recall the enormity of the current credit bubble -- the trillions of dollars of credit created, the trillions borrowed in mortgages and other credit to chase asset prices upward, the trillions created as assets like housing rose in bubblicious euphoria and the trillions extracted from those skyrocketing assets:

Despite the trillions being created, borrowed and pumped into the economy, inflation remained benign:

With all that money flowing around, jobs were relatively plentiful, setting a floor under consumption and consumer credit:

Even as all this money chased goods, services and assets, interest rates fell, earning savers less and less return:

Meanwhile, the capacity to make stuff like steel exploded:

So here's the dynamic which enabled low interest rates and low inflation even as credit exploded and bubbles rose in one asset class after another.

1. Massive expansion of credit was paralleled by a massive expansion of industrial capacity in China and indeed the entire world.

2. This expansion of capacity was matched by an expansion of supply in commodities. As the industrialization of China (one of the so-called BRIC nations--China, Russia, India and Brazil) and other developing nations drove demand for commodities, the incentives to exploit new sources drove up supply of almost everything: oil, iron ore, coffee, etc.

3. While prices have fluctuated in an upward bias, at no time did the cost of commodities rise to levels which threatened global growth except for the oil spike in 2008. Adjusted for inflation, oil is well within historical boundaries even at $80/barrel.

4. To feed the giant credit-dependent machine they'd fostered, central banks kept lowering interest rates and increasing liquidity/money supply. This drove the returns on savings and bonds down to absurdly low levels, forcing money managers to chase riskier assets to make a decent return on investments.

5. This need to earn higher returns drove vast floods of money into assets, inflating one bubble after another.

6. Though consumption also skyrocketed, the vast expansion of industrial capacity and commodity supplies actually outpaced rising consumption, keeping supply and demand more or less in balance and prices relatively stable.

In essence, the hot money was forced to chase assets for higher returns while China's capacity to make goods matched and then exceeded global demand for goods.

The only way credit can drive inflation is if the supply of desired goods is limited. Many of us foresee a time when oil will be that commodity which is no longer able to match demand, but for now, the rise of production in Russia, Africa and elsewhere has kept pace with (now slackening) demand. Indeed, we might well see demand fall enough as the global recession takes hold that oil will fall to $30/barrel.

China's capacity to produce goods now exceeds global demand. Add in the rest of the world's enormous overcapacity and you get deflation, not inflation. In one industry after another, massive overcapacity is the stark reality. For example, the world can manufacture twice as many vehicles as there are customers for those vehicles.

The two key exceptions are grain and oil. If grain supply doesn't match demand, and reserves have been drawn down, then prices could rise suddenly.

At some point oil supply will fall below demand, but when that point will occur is unknown.

Until either or both grain and oil fall into scarcity, then inflation in goods and services has no foundation. As long as interest rates remain near-zero, then the pressure to borrow money and chase asset prices higher remains in force.

No trend lasts forever. At some point interest rates will rise, risky assets will fall from favor and global scarcity in key resources will arise.

How long can the central banks inflate the exponentially-expanding credit bubble? No one knows, but we can say the end-point will arrive when no one wants to borrow more money even at zero interest rates.

Comments

[Michael Clark:]

Charles: Nice report.

Here's an idea for you: monetary inflation in the 1930's and today WILL NOT trigger inflation because of the debt level (our level of insolvency) which makes it impossible for potential lenders to take on more debt and drive prices higher.

In the 70's Americans were not really insolvent -- even though the economy was in serious recession, with double-digit unemployment. Easy money in the 70's did fuel the anti-gravitational forces of inflation because consumers were solvent and, therefore, able to take on more debt to chase prices higher (PUSH prices higher through competition for products and services).

If this is true, then massive amounts of cheap money won't trigger a similar 'inflationary cycle' today as it did in the 1970's. I hesitate to say there is no inflation -- because we've had 20+ years of MASSIVE inflation from 1983 to 2007 -- but inflationary policies will not be able to short-circuit the massive gravitational forces of deflation which will rule until about 2019.

Nov 11 12:41 PM

[Michael Clark:]

correction: "potential BORROWERS' not 'potential lenders'...

Here's an idea for you: monetary inflation in the 1930's and today WILL NOT trigger inflation because of the debt level (our level of insolvency) which makes it impossible for potential lenders to take on more debt and drive prices higher.

Nov 11 01:03 PM

[tunaman4u2:]

Good article

Nov 11 01:26 PM

[Davewmart:]

This is a very thought provoking article.
I would add that some other resources, such as rare earths, whilst they have the potential to cause disruption if supplies became tight, have too low a total value to disrupt a surge in the economy.
The only resource I might add to those mentioned is phosphates.
Although demand in the oil market may be difficult to give a precise forcast for, I would argue that we can do better for oil supplies, as resources take time tol develop.
Here are the calculations of an oil expert and associates:
www.energybulletin.net...

The essential issue is that demand both in the Bric countries and importantly in the main exporters is rising rapidly.
There is little doubt in my mind that in spite of recession severe shortages are likely by around 2015.

What has been unexpected, to me at least, is that gas supplies are so plentiful due to the explolitation of shale resources.
In view of this is is still difficult to work out the consequences of oil shortages, as of course the technology to run transport on gas is perfectly available, although it would involve a fair amount of bodging if done in a hurry.
Just a few thoughts to comment on a fine article.

Nov 11 08:08 PM

[derryl:]

Two things happened in the early 1970s. Nixon delinked the US$ from gold, and the 'energy crisis' and oil price spike. Nixon spent money on Vietnam which put incomes into the hands of wage and salary earners--people who spend their money on consumption and contribute to CPI inflation. Wars are good for getting incomes into the hands of wage earners. Oil is an input cost into virtually every consumer good, especially the transportation component of a good's final price. Both of these factors--spendable incomes and a higher production price structure--contribute to CPI inflation.

In the 1990s globalization flooded Western markets with cheap consumer goods. So even though money was flowing freely, the wage component of CPI costs was kept down by exporting labor to low cost countries. Globalization suppressed Western wages which kept inflation down. Americans and other Westerners kept up their consumption levels with consumer debt, which put even more money into the system to contribute to asset inflation.

Had it not been for globalization, Western wages would have inflated and absorbed the money, and wage earners would have been buying rising price domestic goods, and there would have been the old fashioned kind of wage and price inflation. As it actually happened, the profits from globalization were reaped overwhelmingly by the corporate sector and its shareholders, who tend to be wealthier and to save and invest more, so globalization put money in the hands of investors who inflated assets rather than consumer prices.

Nov 13 12:15 AM